Carbon Pricing

What is carbon pricing?

Policies that put a price on greenhouse gas (GHG) emissions create a market signal to reduce emissions and invest in lower-emitting or carbon removal technologies. Emissions pricing programs require emitters to pay for their pollution. Carbon pricing programs can be designed to minimize consumer cost impacts and protect economic competitiveness.

The main approaches for sending a market signal through a price on carbon are:

  1. Carbon taxes (or carbon fees).
  2. Cap-and-trade (or cap-and-dividend or cap-and-invest).
  3. Hybrid approaches that incorporate elements of both.

Carbon pricing puts a price on the “externalities” associated with GHG emissions.  Economists define an externality as a negative impact on society and the environment but is “free” to the emitter — in other words, a negative side effect or consequence of an industrial or commercial activity and that is not reflected in its cost. Efforts to quantify this negative impact on society are referred to as the “social cost of carbon” or “social cost of methane,” which can be useful tools in regulatory cost-benefit analyses and other policy actions.

These policies can vary in their design details, but their basic features are described below. Under a carbon tax, the government collects a tax from covered or regulated entities that emit GHGs—typically on a per-ton, carbon-dioxide (CO2)-equivalent[1] basis. To reduce their costs from the tax, entities generally will take measures to reduce their emissions, so long as those measures cost less than simply paying the tax. Because of the tax, technologies that are less carbon-intensive would gain a competitive advantage over technologies that are more carbon-intensive – and the continuous price signal tells businesses that it is worth developing innovative technologies and processes to reduce their emissions.

Under a cap-and-trade policy or its variants, the government sets a limit, or “cap,” on overall emissions. The government then issues a quantity of emission “allowances” equal to the cap, either through a free allocation or an allowance auction (or a combination). Entities covered by the policy must hold allowances equal to their total emissions at the end of each compliance period. These allowances can be bought and sold in secondary markets, incentivizing the lowest-cost reductions and leading to a market-derived price for carbon emissions.

A hybrid carbon pricing policy can maximize the strengths and alleviate the weaknesses of a cap-and-trade or carbon tax program in isolation. For example, a cap-and-trade program can include an allowance price floor and/or price ceiling to increase price certainty for market participants. A carbon tax can include an environmental integrity mechanism, which adjusts the level of the tax upwards if certain emissions goals are not met, to increase emissions reduction certainty. Other policies other than cap-and-trade and carbon taxes can also be designed to incorporate market-based elements, such as a clean electricity standard with tradeable permits.

How Do Emissions Pricing Policies Work?

The two primary forms of emissions pricing rely on different mechanisms to achieve their ultimate policy goal of reducing GHG emissions. Cap-and-trade specifies a level of emissions reduction and allows the carbon price to adjust based on market dynamics, while a carbon tax on emissions sets a price but does not guarantee emission levels. In short, a carbon tax provides price certainty, but not emissions certainty, whereas a cap-and-trade system provides emissions certainty, but not price certainty. However, differences between the two approaches can be narrowed significantly through hybrid design.

The two carbon pricing policies also differ in their administration and implementation, though the extent of any differences will depend on details of policy design. A carbon tax generally requires changes to the tax code along with a tax collection mechanism, but it does not require a new market or administrative functions to oversee allowance trading. A cap-and-trade system generally requires the government to establish a regulatory structure, issue allowances, and set up and oversee an infrastructure for tracking allowances and enabling trading. Either policy can be applied to multiple sectors across the economy or to a specific sector.

A policy that drives emission reductions by creating an economy-wide, market-based price signal has the following advantages. It:

  • Is technology-neutral and does not require policymakers to predict in advance where emissions can be reduced most cost-effectively;
  • Will drive energy efficiency investments and the adoption of lower-carbon fuels and products;
  • Will encourage private-sector investment and innovation in new low-carbon technologies; and
  • Could generate federal revenues that can be returned to people via dividend, or used in other ways (e.g., to fund climate change mitigation projects in sectors like forestry and land use that are not covered by the carbon pricing program, fund other budget and policy priorities, reduce other taxes, support job transitions for those in fossil fuel industries, and/or offset costs to businesses and consumers).[2]

While this policy approach does create a long-term market signal for technology innovators, it is less likely than targeted innovation incentives or public research, development and demonstration to prompt the kinds of high-risk, large-scale investments needed to commercialize and deploy cutting-edge technologies with potential for transforming the economy more quickly. This underscores the importance of pairing pricing policies with other, complementary, approaches.

Opponents have also argued that carbon pricing could have negative economic effects. However, proponents cite other academic modeling and real-world experiences that show otherwise. In 2018, the Stanford Energy Modeling Forum Exercise 32 utilized 11 different models to analyze the economic and environmental effects of a range of economy-wide carbon taxes. The researchers found that a carbon tax would lead to significant emissions reductions and the U.S. economy would continue to grow with GDP being affected by less than 1 percent compared to business-as-usual, including under a high carbon tax. Some models found positive effects on GDP which is also affected by how the carbon tax revenue is distributed.

What Are the Key Considerations in Designing a Carbon Pricing Policy?

There are many ways to design a carbon pricing policy. Some top-line considerations include:

For a tax, what is the level of the initial tax and should it increase over time? For cap-and-trade, what is the cap and how should it change over time? Should carbon offset credits[3] be allowed to substitute for some portion of carbon allowances?

What portion of the economy is covered by the policy? Should it be economy-wide or sector-specific? Should it be state-level, regional, or national? And which GHGs should be covered (e.g., CO2, methane, etc.)? Generally, carbon pricing is more effective and efficient when coverage is broad because it provides more options to find the most cost-effective emission reductions.

What entities have the compliance obligation to hold allowances or pay the tax?

For a carbon tax, at what level should government set the tax? For a cap-and-trade system, what compliance cost is considered acceptable and should the system include “safety valve” provisions (e.g., allowance price ceilings and floors) to keep compliance costs within a desired range? Who bears the cost and how are the costs distributed through the supply chain?

How should the revenue from a tax or from allowance sales be used? Should any portion of the revenue be used to offset costs to certain stakeholders, to support advanced technology development, to deploy GHG reduction or carbon removal practices in sectors not subject to the cap or tax, or be recycled back into the general treasury to help fund other budget needs or reduce other taxes?

How would the policy affect different U.S. regions, industries, and populations? Would some bear disproportionate costs and would the benefits be equitably distributed? How should allowances be allocated or sold, or revenue be used to advance fair outcomes?

How would the policy affect the global competitiveness of certain industries, such as energy-intensive manufacturing? How can these competitiveness concerns be mitigated through the program design?

How does the policy interact with other policies and programs, such as technology innovation programs and tax credits?

How can the policy be designed to reduce its weaknesses? Should a cap-and-trade program include a price floor? Should a carbon tax include an environmental integrity mechanism?

U.S. Experience with Carbon Pricing

Several U.S. states have implemented GHG cap-and-trade policies. For example, the Regional Greenhouse Gas Initiative was launched in 2009 to cap and reduce CO2 emissions from the power sector across several Northeastern and MidAtlantic states: Connecticut, Delaware, Maine, Maryland, Massachusetts, New Hampshire, New York, Rhode Island, and Vermont. New Jersey rejoined RGGI in 2020, Virginia will join the program in January 2021, and Pennsylvania is on track to join RGGI in 2022.  RGGI states raised $2.5 billion in auction revenues through 2018, which have primarily been used to fund energy efficiency projects, renewable energy and other GHG abatement projects, along with direct assistance for customers’ electric bills. A 2018 study from the Analysis Group found that between 2009–2017, RGGI states have seen a net economic benefit of $4.7 billion from the cap-and-trade program. Regarding emissions, between the period of 2006-2008 and period of 2015-2017, the annual average CO2 emissions from RGGI electric generation sources decreased by 45 percent (these statistics do not include New Jersey). Due to the many factors that may have contributed to these reductions, such as the economic recession at the start of the program and fuel switching from coal to gas in the electricity sector, it is difficult to determine the exact effect the RGGI program has had on emissions. However, the combination of setting a cap, putting a price on emissions, and investing in energy efficiency have likely contributed to emissions reductions. Some analysts have credited RGGI for over half of the emissions reductions in the region.

California launched a cap-and-trade program in 2013, which now covers electric power plants, industrial facilities, and large[4] fuel distributors. Statewide greenhouse gas emissions decreased 5.3% between 2013 and 2017 and the state met its goal to reduce emissions to 1990 levels by 2020 four years ahead of schedule. California’s program also has raised $12.5 billion in auction revenues through March 2020, which have been allocated to a variety of the state’s policy priorities including low-carbon transportation, affordable housing and land conservation.  The program is designed to act as a “backstop” to California’s other climate policies—inducing the emissions reductions that aren’t caused by other policies. However, it is challenging to determine the exact effect of the cap-and-trade program. California’s Legislative Analyst’s Office found that the state’s lower-than-expected emissions between 2013-2015 were probably primarily a result of other factors such as the economic recession and complementary climate policies but it acknowledged that the program’s price signal likely had some effect on emissions. The cap-and-trade program is expected to have a larger effect on emissions in the future as the state attempts to meet more ambitious emission reduction targets.

At the federal level, the U.S. Environmental Protection Agency implemented the world’s first large-scale pollutant cap-and-trade system in 1995, not to address climate change but rather to address another environmental problem – acid rain.  The policy led to dramatic reductions in sulfur dioxide (SO2) emissions from power plants. Between 1990 and 2004, SO2 emissions fell 36 percent while electricity generation from coal plants increased by 25 percent. Researchers estimated that the costs of these reductions were between 15 and 90 percent lower than alternative regulatory approaches. Despite the success of the SO2 trading program, establishing a national trading program for GHGs has proved more difficult. In 2009, the U.S. House of Representatives passed the Waxman-Markey bill,[5] which would have established such a program for several GHGs, including CO2, from 2012 through 2050. However, this legislation was never taken up by the Senate.

Currently, no U.S. state has implemented a carbon tax. A number of carbon pricing bills have been introduced in the U.S. Congress by Democrats and Republicans, but none have yet come to a vote.

Additional Resources

[1] CO2 equivalent is a metric measure used to compare the emissions from various greenhouse gases on the basis of their global-warming potential, by converting amounts of other gases to the equivalent amount of carbon dioxide with the same global warming potential.

[2]for example, taxpayer dividends or credits funded from revenues from a carbon tax or from the sale of carbon allowances.

[3] Existing U.S. state-level cap-and-trade programs allow carbon offset credits to be used as a compliance option. An offset credit represents one ton of CO2-equivalent GHG emissions reduction or removal (carbon sequestration) that results from an activity outside of activities covered by the policy that meets the government’s approval criteria.

[4] Distributors of fuels that when combusted emit at least 25,000 tons of CO2-equivalent per year

[5] The bill, formally known as the American Clean Energy and Security Act, was introduced by Reps. Henry Waxman (D-CA) and Ed Markey (D-MA)

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